Building A Better Retirement With Dividend Income

Conventional financial planning suggests that you should sell down capital to fund your retirement. I don't like this idea for a variety of reasons. More to the point though, with dividend investing, I don't think you need to touch your capital at all in retirement. Certainly, my aim is to be able to achieve financial independence solely from dividend income.

Financial planners often suggest to retirees that they should assume selling down 3-4% of their capital base (sometimes more) in retirement. This idea is bad for a few reasons.

Markets Crash

As we saw in 2008-2009, markets aren't always rational, and occasionally act like the world is coming to an end. A forced capital selling program can be potentially very negative to your retirement, because you are entirely at the whim of market pricing when you come to sell. A period like 2008-2009 is bad because you can decimate your capital base when you sell capital to cover your living expenses for the year.

This can have knock on effects for later in retirement, and create a need for you to scramble to rebuild your capital base to get you through your retirement horizon. Worse still, you've just broken one of the golden rules of investing, which is to buy low and sell high, and sold investments for much lower than what you could normally sell for.

Having said this, there were valid reasons for the declines that we saw in stock market prices in 2008-2009, but how would those living off just their dividend income have done?

Across the S&P 500, dividends were down by some 20% in 2009. That's certainly a rough year, and anyone reliant on dividend income would have likely seen declines on that income. That's still much better in comparison to the declines in stock prices, which fell close to 50% over 2008 to 2009.

So while someone who relied on their dividend income to fund their retirement would have certainly felt some pain during the 2008-2009 period, they likely wouldn't have felt anywhere near as much pain as someone who had to sell a fixed amount of capital each year.

Reducing The Value Of The Nest Egg That You Pass On

Forced selling of capital throughout retirement reduces the value of the asset that one can ultimately pass on. It also removes the ability for capital to grow and compound throughout a retirement period had it just been left there untouched.

You can imagine the huge difference in the value of a retirement sized nest egg that has compounded for 20 years in retirement to one that has been pared down with capital withdrawals every year.

A Dividend Retirement

I think it is possible to live off your dividends through your retirement if you have stocks that can generate dividend growth greater than inflation. This is provided that you have properly estimated your living expenses during retirement, and have passive income that exceeds these expenses.

It is no trivial challenge to amass the amount of capital that can comfortably throw off an increasing dividend stream to cover expenses through retirement. However, even if you haven't been able to start investing as early as you like, its still possible to amass a steadily growing dividend stream by looking at slightly higher yielding stocks, like Verizon Communications (NYSE:VZ), for instance, that pay solid dividend yields and provide more modest increases in dividend growth. This will allow you to accelerate your dividend income stream while still having modest ongoing dividend increases to cover inflation during your retirement.

Steady Businesses With Sustainable Growth

The best candidates to help fund dividend retirement income are those businesses that are able to consistently grow earnings, cash flow and dividend income, and that have shown a sustained ability to do so over a lengthy period of time. Having a need to rely on these businesses to deliver consistent dividend income for the length of retirement means that businesses with wide economic moats and strong competitive advantages are critical. In my view, some of the types of businesses that potential retirees should look at include:

McDonald's Corp. (NYSE:MCD): McDonald's Corp. sells and operates fast food restaurants selling food, soft drink and other beverages globally via franchisees. Founded in 1950, McDonald's is a $95B company with revenues close to $27B and gross margins around 40%. A large, well known brand and operational efficiency give McDonald's a sustainable competitive advantage and economic moat. With a current yield of 3%, McDonald's has increased operating cash flow at greater than 10% per annum in the 2006-2011 period, with dividend growth of greater than 20% per annum over this period.

The Coca-Cola Company (NYSE:KO): The Coca-Cola company manufactures, markets and sells beverages worldwide, including such well-known products as Coke, Fanta and Sprite. Founded in 1886, the Coca-Cola Company is a $167B company with revenues close to $47B and gross margins around 60%. A large well known brand, intellectual property and marketing and distribution scale give the Coca-Cola Company a large economic moat. With a current yield of 2.7%, the Coca-Cola Company has increased operating cash flow at almost 10% per annum in the 2006-2011 period, with dividend growth of close to 9% per annum over this period

Automatic Data Processing (NASDAQ:ADP): Automatic Data Processing provides a range of outsourcing services for payroll, time management and tax administration. Founded in 1950, Automatic Data Processing is a $30B company with revenues close to $11B and gross margins around 40%. The payroll services provided by Automatic Data Processing have significant switching costs, given once payroll services are deployed, they become difficult to replace. This gives rise to an economic moat for Automatic Data Processing. With a current yield of 2.65%, Automatic Data Processing has increased operating cash flow at almost 8% per annum in the 2006-2011 period, with dividend growth of close to 12% per annum over this period.

As we saw in 2008-2009, having an explicit goal of forced stock selling to fund retirement can leave someone vulnerable to selling capital at the worst possible time. Funding your retirement solely through the income from dividend paying stocks can help ensure that you won't be dependent on market conditions to provide for your living expenses when the next financial crisis comes along.

Disclosure: I am long MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.